Why is average costing dangerous for manufacturing
You’ve probably been told that average costing is the simplest way to value your inventory. Your accountant might have even recommended it because it’s “easier to manage” or “smooths out fluctuations.”
And they’re right for compliance purposes. Average costing works perfectly well for your statutory accounts. It satisfies the accounting requirement that stock must be valued at the lower of cost and net realisable value. Your year-end accounts will be fine.
The £1m to £10m Manufacturer’s Breakthrough Plan
But here’s the problem: what works for compliance doesn’t work for running your business. Average costing gives you accurate financial statements whilst feeding you completely unreliable information for pricing and production decisions.
It hides the very information you need to run your manufacturing business properly.
What Average Costing Actually Does
Average costing takes all your purchases of a material bought at different times and different prices and blends them into one average cost. Sounds logical, right? Buy steel bar at £3.20 per kilo in January, £3.80 in March, and £3.50 in June, and your system records it all at roughly £3.50.
Product Costing Accountant – Skynet Accounting – Accountants For Manufacturing & Engineering
The problem is that £3.50 figure doesn’t represent any real purchase you actually made. It’s a mathematical fiction that sits somewhere in the middle of your actual costs.
For your annual accounts, this might be acceptable. For running your manufacturing business day-to-day? It’s dangerous.
Why Manufacturing Margins Can’t Tolerate Fiction
Manufacturing operates on tight margins. You’re pricing jobs based on material costs that fluctuate constantly metals, polymers, chemicals, timber.
A 15% swing in raw material prices isn’t unusual. Currency movements affect your imported materials weekly. Supply chain disruptions can spike costs overnight.
How to Double Revenue in CNC & Laser Cutting Industry
When you quote a job in February using average costs from December, you’re basing your price on old data. If material prices have risen 12% since then, you’ve just quoted 12% below your actual cost. You’ll only discover this months later when you review your margins and wonder why that “profitable” job lost money.
Average costing creates a lag between market reality and your decision-making.
In manufacturing, where material prices move fast and margins are tight, that lag is fatal.
The Hidden Dangers Nobody Talks About
You’re pricing jobs with ghost figures. Your estimating system pulls average costs, but those materials will be purchased at today’s prices which might be significantly higher. You think you’ve priced in a 28% margin. In reality, you’re working to 18%, or break-even, or even a loss.
You can’t track batch-specific costs. Manufacturing often involves different batches of the same material with different specifications or quality grades. Average costing lumps them together. You lose visibility of which batch went into which job, making quality tracing nearly impossible when issues arise.
7 Quick Wins to Protect Profit & Cash in Manufacturing
Your stock valuation is wrong. That stack of aluminium sheet in your stores might include material bought at £2,800 per tonne last year and £3,400 per tonne last month. Average costing values it all at £3,100. But if you need to use the older stock first (sensible practice), you’re actually consuming £2,800 material whilst your system thinks you’re using £3,100. Your true profit is higher than reported, but you don’t know it.
Manufacturing Efficiency Audit – Skynet Accounting – Accountants For Manufacturing & Engineering
Material substitutions become invisible. When your buyer switches from the specified material to an approved alternative because of availability, average costing might hide the cost difference entirely. You’ve just changed your build cost, but your system hasn’t noticed.
What You Should Use Instead
FIFO (First In, First Out) values your stock based on the actual oldest purchase price, which is usually what you’ll physically use first. When you consume materials, they’re costed at the oldest purchase price in your system. This matches your physical reality you generally use older stock before newer stock to manage stock rotation and shelf life.
Electronics Manufacturing Bottleneck Operations
FIFO gives you real costs based on real purchases. When you quote a job, you’re using actual recent purchase prices, not averaged historical ones. If prices have risen, FIFO reflects that immediately in your stock valuation and job costs.
Standard costing sets a planned cost for each material, then tracks variances between standard and actual. You quote jobs at standard cost, but you monitor every variance. When steel prices jump 18%, you see it immediately as a purchase price variance.
You can react, revise quotes, renegotiate with customers, or find alternative materials.
Standard costing requires more setup, but it gives you control. You decide the cost baseline, and your system tells you when reality deviates from plan.
Making The Switch
Yes, changing your costing method requires work. Your accounting system needs reconfiguring. Your team needs training. You’ll need to revalue inventory. If you’re mid-year, you’ll want to plan the transition carefully to avoid distorting your annual accounts.
But the alternative is continuing to make pricing decisions based on fictional numbers whilst your competitors work with real data.
Your Next Step
If you’re still using average costing, pull up a recent job that disappointed on margins. Compare the material costs you quoted against what you actually paid. Calculate the difference.
That gap is the price you’re paying for using the wrong costing method.
Need help assessing whether your current costing system is fit for purpose? I work specifically with UK manufacturing and engineering businesses to implement proper production costing systems that reflect real costs.
Get in touch for a straightforward conversation about what your business actually needs.
Apply For a Call – Skynet Accounting – Accountants For Manufacturing & Engineering
Follow me on LinkedIn: www.linkedin.com/in/skynet-yesim-tilley
About the Author
Written by Yesim Tilley Founder of Skynet Accounting is a chartered accountant with over 20 years of experience supporting manufacturing and engineering businesses across the UK. Specialising in cost analysis, product costing, and financial strategy, she helps industrial businesses understand their numbers and make more profitable decisions. Skynet Accounting provides tailored finance, compliance, and taxation support designed specifically for the manufacturing and engineering sector.